Think of it this way: Everyone has a comfort zone when it comes to weather. Some people like the hot temperature of the south; some like the cooler, wetter climates in the northwest; still others would rather have a seasonal variety, like you get in the north. It can be similar with your investment comfort zone. There is no single answer that’s right for everyone. It’s what you decide is most comfortable for you. To understand your investment comfort zone and the type of investor you are, you’ll need to consider where you are in your life, what goals you want to accomplish in retirement, and what level of risk you’re comfortable with in your portfolio.
Knowing your investment comfort zone matters.
Understanding the type of investor you are is particularly important for a number of reasons:
- If you’re too complacent, you may be ignoring risk.
- You need to recognize when risk is increasing or decreasing.
- If you’re an uncomfortable investor, you may allow your emotions to take control of your decisions.
- You want to minimize the possibility that you may need to make difficult decisions under pressure.
The three primary types of market investing
Investing in the market always involves a level of risk. That’s why it’s essential for you to know how much gain or loss is acceptable to you, and what level of risk you’re comfortable with.
Remember, there is nothing fundamentally better about being a risk-taker or risk-advisor. Sometimes the greatest risk is taking no risk at all. Understanding your risk tolerance as well as your overall objectives and goals can help determine the type of investment that is appropriate for you.
Generally people think of three main types of investments: stocks, bonds, and cash or cash equivalents. All of these types of investments have advantages and disadvantages, depending on how the market is reacting at a particular time period. Whichever investments you choose, you need to consider the opportunities for gains, losses, liquidity, tax advantages, and consequences.
Although stocks may give you the opportunity for bigger gains over time, they can also be the most volatile. To most investors, particularly those who invest in equities, volatility is something to be aware of. The stock market can change from year to year and can be volatile, as the chart below displays. Most of us recall the “Lost Decade” from 1999 to 2009, when investors saw the S&P 500® Index drop more than 40% at the height of the 2008 financial crisis.
When the markets are volatile, the typical reaction is to want to get out of the market altogether and move your money into safer alternatives. But if you had done that following the 2008 market crisis, you would not have captured the rebound in the market the following years.
When determining your Investment Comfort Zone, think about: What is your time horizon (the amount of time before you’ll need your money)? What is your plan if the markets go down? Ask yourself, how is your portfolio protected?
Bond funds have been solid investments in a retirement strategy for many years. As fixed income investments, bonds help provide diversification, stability, and tax benefits to almost any portfolio.
Generally speaking, people tend to avoid the risks they are aware of. That’s why, in recent history, people have sought to reduce their exposure to losses caused by volatility by switching from investing in the stock market, to investing in the bond market.
And while bonds are generally seen as a safer alternative, they are susceptible to a different kind of risk, due to their inverse relationship to interest rates. With interest rates currently still near historic lows, bonds can offer higher returns, making them more desirable to investors and driving bond prices higher.
But as the graph shows, we’ve had three decades of a general decline in the baseline for interest rates. Now interest rates can’t go much lower- and when they begin rising, the value of existing
bonds moves in the other direction. Your bonds would then be worth less in order to keep the returns they offer competitive with the higher interest rates of newly issued bonds.
So if you’re holding a disproportionate amount of your retirement assets in bonds, you may have more risk in your portfolio than you realize. While bonds should continue to be part of a well-balanced portfolio for most clients, you need to be aware of how a rising interest rate environment could affect your portfolio.
Cash and cash equivalents
We all know how important it is to have some money in a savings account or short-term investment such as a money market account. By keeping money liquid (i.e., as cash, or as an asset that can be quickly converted into cash), it will be available at the time you need it. But it is also important to discuss how much is enough, and when an amount of cash might negatively affect your accumulation goals.
As you can see, the value of a dollar is projected to erode due to the effects of inflation over time, so you need to consider this potential “cost” versus the convenience and relative safety of holding assets as cash.
So while cash can play a role as a part of your retirement plan, cash alone will likely not help you reach your financial goals. Given this, it might make sense to balance your portfolio by shifting some low-earning cash to investments with higher growth potential.
A 2013 Psychology Today article discusses economic research and emotional investing. Specifically, that emotions play a significant role in how people make financial decisions. But one of the most common mistakes investors can make is to let emotions guide their investment decisions. That’s why it’s important to understand the impact that emotional investing can play in your investment decisions. Because investors tend to focus on short-term gains and losses, emotions can run high in both directions. When the market is up, we are all relaxed and confident in our investments. But when the market goes down, anxiety can set in and our first reaction is to pull out our money from the market and move it to a safer place.
When we act on this impulse, we are allowing our emotions to make our investment decisions. Remember, the ability to “time” the market- to predict which direction the market will move at a point in time and invest accordingly- is virtually impossible. (If it was more possible, we’d all be rich.)
The investment cycle as emotional cycle as shown on the graph below, people typically get most excited about investing when market prices are at their highest.
You could think of it as the “overconfident” stage, but it can also be the stage of greatest risk. Because this is the market’s high point, as it starts going down, investor confidence often follows, giving way to nervousness and worry.
People may tend to wait it out for a while, but as panic and discouragement set in, they may decide it’s time to get out of the market. By shifting their investments into cash, the thinking goes, they can avoid additional market downturns.
Unfortunately, by exiting when prices are lower (or even at their lowest), they’ll lock in their losses – meaning they’ve given up their chance to regain value when the market starts rising again.
Are your emotions driving your investment decisions?
After you have made your plan for retirement, and the market inevitably goes up and down, will you be willing to stay the course through the highs and lows? Or will you overreact to the market and make decisions based on emotion?
Rebuilding your assets after a big loss takes time. It’s simple mathematics: the more value you lose, the more you’ll need to gain back in percentage terms to fully rebuild from your losses.
Always keep in mind that the decisions you make may affect not just your portfolio’s total value, but can also impact your timeline for retiring. Make sure you have enough time to recover from any market correction to meet your goals.
Finding your personal Investment Comfort Zone
Understanding your Investment Comfort Zone begins by working with your financial professional and reassessing it on an annual basis.
The type of investor you are takes into account your financial goals, your time horizon, and your tolerance for risk. And just because you think you are one type of investor today doesn’t mean you can’t change over time as your needs, goals, or attitudes change.
When determining your Investment Comfort Zone, here are some points to consider:
- What accumulation goal is necessary to meet your future retirement needs?
- What financial changes could change your Investment Comfort Zone?
- What mix of investments is suitable to achieve your retirement goals?
- Have you taken on an unnecessary amount of risk to reach your goals?
- Can you maintain financial discipline when you are faced with changing market conditions?
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